Opinion: Stocks, any way you slice them, are no bargain

The six-year-plus boom on Wall Street has left the U.S. stock market overvalued on 13 of 18 historic measures, according to research by Bank of America Merrill Lynch.

And while the bank’s analysis does not suggest, or even imply, that the market is poised to crash, as the doom sayers like to predict, it does suggest there’s a significant risk that long-term returns may be below-average.

Based on the benchmark S&P 500 Index, Bank of America/ML
BAC, -0.80%
strategists found stocks are above their long-term trends when compared with a whole gamut of gauges, including last year’s and next year’s earnings, growth rates, operating cash flow, gold, net asset values and the overall size of the economy.

In many cases, the degree of overvaluation was slight. However, when the strategists removed the wacky days of the 1990s dot-com bubble from the historical data, the picture looked worse. For example (as of June 30), the stock market traded for an average 17.4 times per-share earnings of the past 12 months, compared with an average of 15.3 since 1960, excluding the tech bubble (and 16 times when you include it). Stocks are valued at 12.3 times annual operating cash flow, compared to 9.6 since 1986 (again, excluding the bubble).

There’s a popular industry on Wall Street these days that consists of mocking any measure that suggests the stock market is expensive.

Any individual measure is subject to hefty caveats, but it gets harder to argue that the stock market is a bargain when you look across the board. Some of the measures with the longest track records seem to look the worst. The cyclically adjusted price-to-earnings ratio, which compares stocks to the average per-share earnings of the past 10 years, has been tracked with data back to 1881 by Yale University finance professor Robert Shiller. By that standard, stocks are 61% above their long-term average.

The so-called “Warren Buffett indicator,” which compares the value of the stock market with the size of U.S. gross domestic product, suggests stocks are overvalued by nearly 100%. (It is known as the Buffett indicator because the fabled investor has sometimes offered it as a rough rule of thumb about the market.) But there are issues with this indicator, as the bank acknowledges. These days, big U.S. companies such as Apple
AAPL, +0.63%
and Exxon Mobil
XOM, +0.54%
are so global that it makes little sense to compare them solely with the U.S. economy.

There’s a popular industry on Wall Street these days that consists of mocking any measure that suggests the stock market is expensive. Every time share prices rise, after all, the skeptics look even more foolish. But markets can be overvalued for many years before they correct. (How stupid the gold skeptics looked a few years ago, as the metal rocketed relentlessly toward $2,000 an ounce). And, naturally, the higher that shares rise, the less good a deal they become.

The Bank of America report may have understated the grounds for skepticism.

First, the bank didn’t include the measure known as “Tobin’s Q,” which compares share prices with the replacement cost of company assets. That has one of the longest pedigrees of them all and makes Wall Street look almost poetically overvalued.

Second, the metrics suggesting stocks may still be a good value include several that are merely relative measures — such as those that say S&P stocks are cheap in relation to booming bonds or small-caps.

And, third, the “historic averages” in most cases only go back a few decades. Not only is that a mere blink of an eye in historic terms, but it is massively skewed toward the biggest bull market in history, that from 1982 to 1999. As such, it ignores the experience of previous decades, such as the 1910s, 1930s and 1970s, when things on the stock market got bad just before they got even worse.

It’s important to remember that, historically, U.S. stocks have produced superlative long-term returns, so even if the market is expensive by the standards of history, shares may still be a good bet — just not as good as they have been on other occasions.

The real danger is not that “Wall Street is about to crash” or that stocks are “certain” to do badly over the next 10 years. It’s that too many investors and money managers have completely dismissed the possibility that the next 30 years may look completely unlike the last 30. Anyone with even a basic understanding of history should know better.

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